Commercial Real Estate Investments (REITs)
When most investors think about investing in real estate, their primary residence or residential real estate comes to mind. But there’s another investing opportunity available: commercial real estate. This includes the ownership or partial ownership of the office properties people work in, the retail properties people shop in, and the hotels people stay in when they travel. The concept may seem unattainable, but it is more accessible than you may think.
WHY INVEST IN COMMERCIAL REAL ESTATE?
Many investors invest in commercial real estate to help:
1. Diversify a portfolio
2. Generate potential total returns
3. Hedge against inflation
Diversify a portfolio
Asset allocation—the act of distributing assets among different asset classes (e.g., stocks, bonds, and cash equivalents)—is a main tenet of modern portfolio theory. By investing in a diversified portfolio of assets with historically low correlations (i.e., they were less likely to perform similarly through various market cycles), an investor may be able construct a portfolio that generates higher risk-adjusted returns. In other words, through diversification, an investor may be able to generate a certain level of returns with the lowest possible portfolio volatility. Of course, diversification does not assure a profit or protect against loss during a declining market.
Historically, commercial real estate has fit the bill of a portfolio diversifier and has become an important building block in many investor portfolios. As an asset class, commercial real estate may react differently to certain economic variables than traditional operating companies; thus, its returns may zig when other assets classes’ returns zag.
Generate total returns
Commercial real estate investment returns generally come from two sources: income and capital appreciation. Income return is derived from the ongoing operations of the property or portfolio of properties. In most cases, the commercial property owners collect rents (revenue) and pay out financing and operating costs (expenses). The difference between the revenue and expenses may be passed on to the property owners in the form of an ongoing income yield.
Capital appreciation is measured as the difference between the initial investment (plus capital improvements) and the amount returned when an investment is sold. The ultimate outcome can be affected by property-specific factors (e.g., change in the property’s occupancy rate), location factors (e.g., new supply entering the market as the result of development), and/or macroeconomic factors (e.g., market capitalization rate changes due to a perceived change in the risk environment).
Hedge against inflation
While real estate has tended to be cyclical, commercial real estate has been considered an inflation hedge due to a number of factors. First, as the price of goods and services rises, so may the rental rates that property owners can charge tenants. Second, replacement cost is a significant factor in determining when new development occurs. As construction and material costs increase due to inflation, existing properties may also rise in value before additional competitive supply is added to the market. And third, due to commercial real estate’s high percentage of capital or fixed assets, inflationary pressures (which tend to affect variable inputs like labor costs) have tended to have a limited effect on the expense side of a real estate portfolio’s income statement.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
Dennis McCurdy, CIC, CFP® is a financial advisor located at Dennis A. McCurdy & Associates, 212 Main St., Sturbridge, MA 01566, He can be reached at 508-347-8107 or at dmccurdy@mccurdyinvestments.com.